Analysis: For euro zone, the heat is on again

By IBT Staff Reporter On 01/09/12 AT 3:16 AM

The euro zone crisis seemed to vanish from the headlines for a brief moment as 2011 ticked over into 2012, but it is about to return with a vengeance.

The coming months will be decisive in determining whether European leaders can hold their increasingly fragile currency bloc together or will stumble in the face of a daunting set of political, economic and financial obstacles lined up in their path at the start of the new year.

In Greece, where the crisis started over two years ago, the government is in a race against time to agree a bond-swap deal with banks that is crucial to a new 130 billion euro bailout package from European partners and the International Monetary Fund (IMF).

Without that package, Athens faces the threat of a debt default in March.

But talks with the banks and investment funds that are being asked to accept 50 percent losses on their Greek bonds to help pay for the bailout have dragged on for weeks, sowing doubts about whether Athens can really deliver.

The risk of a disorderly Greek default is once again on the rise, with the threat of contagion to Italy and others, economists at Barclays Capital said last week.

Compounding the challenge, both Greece and France face elections within months that could complicate decision-making at the national level in two key states and thwart the broader bloc's ability to act swiftly at a time when pressure is high to bed down agreements sealed at an EU summit last month.

A key element of the summit package was a deal to funnel 200 billion euros to the IMF, money that could be used to offer precautionary credit programs to Italy and possibly Spain.

But the euro zone is struggling to get the 50 billion euros it needs from nations outside the currency bloc to meet its goal. A senior German official told Reuters on condition of anonymity that securing the participation of Britain, which has shown no inclination to contribute, was absolutely crucial.

Even if those funds are secured, neither Italy nor Spain have shown any willingness to accept aid -- and the stigma and greater fiscal oversight that would come with it.

Italian 10-year bond yields have pushed back above the 7 percent mark over the past week, approaching record euro-era highs, and both Rome and Madrid must sell bonds this week in the first major market tests of 2012 for the euro zone's third and fourth biggest economies.

END OF MERKOZY

The Greek election, expected by the end of March, seems unlikely to produce an outright winner, meaning coalition talks could drag out and prolong uncertainty.

In France, polls suggest there is a good chance President Nicolas Sarkozy, who has steered Europe's crisis response along with German Chancellor Angela Merkel, could be pushed out of office by his Socialist challenger Francois Hollande.

While Merkel and Sarkozy have polar-opposite temperaments and clashed frequently when the Frenchman first took power in 2007, they are both conservatives, born just half a year apart, and have developed an effective, even close, partnership after years of high-pressure crisis summits.

And after years of frustration with the French president's shoot-from-the-hip style, government officials in Berlin say they are now worried about the end of Merkozy, the most important relationship in Europe, in the middle of the crisis.

A cut in France's triple-A credit rating in the weeks ahead could also upset the delicate Franco-German balance, although some economists believe it could force the French to accept more far-reaching fiscal reforms, regardless of who wins the two-round election in April and May.

It won't be Merkozy anymore. It will be Angela Merkel and (IMF chief) Christine Lagarde dictating policy in Europe, said French economist Jacques Delpla.

The next French president, whether its Hollande or Sarkozy, won't have many options. The deficit will need to be cut, taxes increased and spending cut.

RECESSION RISK

Fittingly, Merkel and Sarkozy kick off 2012 with a Monday meeting in Berlin to prepare an EU summit scheduled for January 30 that is expected to focus on efforts to boost growth.

That is perhaps the biggest challenge of all for the bloc. After several years of fiscal consolidation to push down debts and deficits swollen by the global financial crisis of 2008/09, the euro zone is headed for recession -- a factor that has pushed the euro down to 16-month lows against the dollar.

Even the bloc's economic powerhouse Germany is at risk of recession. Greece is entering its fifth straight year of contraction, with no hope of paying down its massive debt.

But restoring market confidence in the finances of struggling euro area countries and getting their economies working again seem like contradictory goals at this point.

In the current market environment there is no room for using a Keynesian-type expansionary fiscal policy to boost demand in countries with low growth - the markets will simply not accept such a strategy, Deutsche Bank said in a confidential note on the crisis prepared for the German government late last year.

One bright spot is the European Central Bank (ECB), which is showing greater flexibility under its new President Mario Draghi, euro zone officials say.

The ECB's decision last month to provide cheap long-term loans to banks has helped assuage fears about the financial sector and could support sovereign debt sales going forward.

We're already seeing that Draghi is more flexible than Trichet, the senior German official said, referring to the Italian's French predecessor Jean-Claude Trichet. He won't put a bazooka in the window for everyone to see but he'll do what it takes.

The big question is whether this buys Europe's leaders the time they need to overcome the formidable challenges they face in the new year.